October 16, 2018

Extended Backtest of Global Equities Momentum

In 2013, I created my Global Equities Momentum (GEM) model that applied dual momentum to stock and bond indices. We hold U.S. or non-U.S. stock indices when stocks are strong. Bonds are a safe harbor when stocks are weak.

When my book was published in 2014, I had Barclays bond index data back to 1973. Since one year of data is needed to initialize the model, GEM results were from 1974 through 2013. In 2015, I gained access to Ibbotson Intermediate Government bond data. This let me extend GEM back to 1970.

The extra bond data let us see how GEM performed during the 1973-74 bear market. GEM was up 20% those two years, while the S&P 500 index was down over 40%. This was a short out-of-sample validation of our dual momentum approach.

I thought 1971 was as far back as I could ever take GEM because MSCI non-U.S. stock index data only went back to 1970. But I recently obtained longer-term Global Financial Data (GFD) of non-U.S. stock indices. It is not as robust as cap-weighted MSCI data. Before 1970, GFD uses fixed country weights that adjust periodically. But it would still be interesting to see how GEM looks with the earlier GFD data compared to GEM since 1971.

Global Investing

We usually want as much data as we can get to confirm an investment strategy. But we also have to consider how realistic our results will be under earlier conditions. Dynamic global investing, for example, makes little sense during the two World Wars. In WWI, there were strict capital controls that made it almost impossible to invest globally. These eased up some during the 1920s. But they strengthened again during the Great Depression. During WW II, they were the strongest they had ever been.

Even if you could have invested globally then, it would have made little sense. Imagine a U.S. investor going to a cocktail party and saying you bought German, Italian, or Japanese stocks. You would never get invited to another party. If you were an institutional investor, you would lose all your clients.

Global investing would have also been imprudent and very high risk. Right after WW II, German stocks lost 91% of their value, and Japanese stocks fell 97%.

Source: Dimson, Marsh & Staunton, Triumph of the Optimists:101 Years of Global Investment Returns, Princeton University Press, 2002

So, what is a good starting date for global investing? The first academic paper to point out the benefits of international investing was in 1968 [1]. There were similar papers in 1970 and 1974 [2]. The first mutual fund to make global investing available to U.S. investors was Templeton Growth Fund that began in 1954. Asness, Israelov, and Liew (2017) in “International Diversification Works (Eventually)” begin their study in 1950 using GFD. This seems reasonable. We will use January 1949 as the starting time of our data. GEM results can then begin on January 1950.

Data Sources

We use the S&P 500 index for U.S. stocks. For non-U.S. stocks, we use the MSCI All Country World Index ex-U.S. from its start date in January 1989. It includes both developed and emerging markets. By using as broad an index as possible, we avoid possible selection bias. Before 1989, we use the MSCI World Index ex-U.S. from its start date of January 1970, and the GFD World Index ex-U.S. before then. These indices have only developed markets. For bonds, we use the Barclays U.S. Aggregate Bond Index from its start in January 1973. It holds investment grade (70% government) bonds with an average duration of 5 to 6 years. Before 1973, we use the Ibbotson Intermediate Government Index of 5-year government bonds.

GEM Model

When the trend of stocks is up according to absolute momentum applied to the S&P 500, we use relative strength momentum to determine if we will be in U.S. or non-U.S. stocks. When the trend of stocks is down, we invest in bonds. We use a 12-month look back period and rebalance monthly. A 12-month look back was effective in Cowles & Jones’ 1937 study. It also worked well in Jegadeesh & Titman’s (1993) seminal momentum research. A 12-month momentum look back soundly beat buy-and-hold from the beginning of stock market trading in the 1600s and with other assets back to 1223 as reported by Greyserman & Kaminski (2014). For more details about GEM, see my book.

GEM Results

Here are GEM results compared to a global asset allocation (GAA) benchmark of 45% U.S. stocks, 28% non-U.S. stocks, and 27% 5-year bonds. This is the amount of time GEM was in each of these markets. It is also representative of a typical global asset allocation portfolio.

                                               Jan 1950- Sep 2018    Jan 1950- Dec 1979   Jan 1980- Sep 2018


 GEM
GAA
GEM
GAA
GEM
GAA
CAGR
15.8
10.0
13.9
9.6
17.3
10.3
Annual Std Dev
11.5
9.8
10.2
8.3
12.4
10.9
Skewness
-0.09
-0.54
0.30
-0.24
-0.29
-0.63
Sharpe Ratio
0.96
0.57
0.72
0.39
1.03
0.58
Worst Drawdown
-17.8
-41.2
-15.8
-29.3
-17.8
-41.2
Worst 6 Months
-15.7
-33.0
-15.7
-21.0
-15.0
-33.0
Worst 12 Months
-17.8
-35.7
-13.3
-28.1
-17.8
-35.7
% of Profit Months
69
67
67
68
72
63

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.




Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

The correlation in monthly returns between GEM and GAA is 0.60 and between GEM and the S&P 500 index is 0.50.

These results are updated monthly on the Performance pages of my website.

Relative versus Absolute Momentum


To better understand what is going on within GEM, I separated out its two components, relative and absolute momentum.


GEM
REL MOM
ABS MOM
S&P 500
CAGR
15.8
13.4
12.3
11.4
Annual Std Dev
11.5
14.4
11.2
14.2
Sharpe Ratio
0.96
0.64
0.7
0.52
Worst Drawdown
-17.8
-54.6
-29.6
-51.0
Worst 6 Months
-15.7
-41.8
-25.2
-41.8
Worst 12 Months
-17.8
-48.1
-25.3
-43.3
% of Profit Months
69
65
67
64

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

Relative momentum is where we switch between U.S. and non-U.S. stocks based on their relative strength. It still suffers from equity-like drawdowns. But for investors with a mandate to always be in equities, relative momentum gave 200 basis points more in annual return than the S&P 500.

Absolute momentum had 90 basis points more in annual return than the S&P 500. Its lower return than relative momentum is due to occasional whipsaws and lags in getting in or out of equities at their turning points. But absolute momentum gave reduced drawdowns.

There is a synergy in combining both types of momentum. Their combined whole is greater than the sum of their parts. If you reduce bear market exposure using absolute momentum, you gain more from relative momentum in bull markets. For example, the average bear market loss of the S&P 500 index since 1950 is 33%. It takes a 50% gain to recoup that size loss, and the stock market gains about 10% per year. So, it can take 5 years on average to reach breakeven. If absolute momentum reduces bear market losses, then bull market gains become new profits instead of making up these losses. That is why GEM shows an impressive 440 basis point increase in annual return above the S&P 500 from 1950 until now, versus 200 basis points for relative momentum and 90 basis points for absolute momentum. As with absolute momentum, GEM returns were achieved with considerably reduced downside exposure.

Here are tables showing how absolute and relative momentum performed during bull and bear market cycles.

BULL MARKETS
S&P 500
Abs Mom
GEM
Jan 1950- Dec 1961
647.7
608.3
1014.6
Jul 1962- Nov 1968
143.7
66.7
58.0
Jul 1970- Dec 1972
75.6
47.2
84.0
Oct 1974- Dec 1980
198.3
91.6
103.3
Aug 1982-Aug 1987
279.7
246.3
569.2
Dec 1987- Aug 2000
816.6
728.4
730.5
Oct 2002-Oct 2007
108.3
72.4
181.6
Mar 2009-Dec 2017
338.7
177.4
142.3
AVERAGE
326.1
254.8
360.4


BEAR MARKETS
S&P 500
Rel Mom
GEM
Jan 1962- Jun 1962
-22.8
-18.5
-15.7
Dec 1968- Jun 1970
-29.3
-13.9
   4.3
Jan 1973- Sep 1974
-42.6
-35.6
 15.1
Dec 1980- Jul 1982
-16.5
-16.9
 16.0
Sep 1987- Nov 1987
-29.6
-15.1
 15.1
Sep 2000- Sep 2002
-44.7
-43.4
 14.9
Nov 2007-Feb 2009
-50.9
-54.6
-13.1
AVERAGE
-33.8
-28.3
   0.9

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

Absolute momentum alone gave less profit than the S&P 500 during bull markets. But dual momentum-based GEM produced more profit. Relative momentum by itself suffered nearly the same bear market losses as the S&P 500. But GEM, over the long run, eliminated those losses over this 68 year period.

 Core Versus Satellite


Fama and French call momentum "the premier anomaly." With the growth in factor-based investing, more investors are now willing to use momentum in their portfolios.

Trend following has also been gaining traction. Academic research on trend over the past few years as shown here, has switched from hostility to skepticism to acceptance.

More often than not, those who invest in momentum or trend use it as a satellite rather than a core holding. This may be due to anchoring or familiarity bias. There is also a strong home country bias that reduces aggregate investing in non-U.S. stocks. Some investors may also not fully appreciate dual momentum as a dynamic rather than a static way to diversify. Others might have long-standing prejudice against timing stock market entries and exits.  Burton Malkiel, a popular proponent of efficient markets, famously said, “Don’t try to time the market. Nothing could be more dangerous.”

For investment professionals, there is also potential career risk. All strategies that diverge from the market will at times underperform. If you lose money when everyone else is losing money, you will likely keep your clients. But that changes if you are doing something different and lose money when others are not. Clients who are not well-educated about quantitative investing may leave. Ironically, the biases that keep many investors away from dual momentum are reasons why it works as well as it does. The behavioral explanation of momentum starts with underreaction to relevant information.

You can never be sure of the future, and there will always be tracking error when you deviate from a benchmark portfolio. So we can understand those who may be more comfortable having multiple investments. Here are some allocation scenarios to consider. They show GEM combined with GAA over the past 68 years.


GEM
75%/25%
50%/50%
25%/75%
 GAA
CAGR
15.8
14.4
13.0
11.5
10.0
Annual Std Dev
11.5
10.4
9.8
9.7
9.8
Sharpe Ratio
0.96
0.92
0.85
0.73
0.57
Worst Drawdown
-17.8
-21.2
-28.1
-34.9
-41.2
Worst 6 Months
-15.7
-14.6
-17.0
-25.3
-33.0
Worst 12 Months
-17.8
-21.2
-24.6
-28.0
-35.7
% of Profit Months
69
69
68
68
67

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.


 [1] Grubel (1968), “Internationally Diversified Portfolios: Welfare Gains and Capital Flows
 [2] Levy & Sarnat (1970), “International Diversification of Investment Portfolios,” Solnik (1974), "Why Not Diversify Internationally Rather Than Domestically?